Goldman Sees Fear of 'Cliff' Hitting Stocks Next Quarter

Goldman Sachs strategists expect the “fiscal cliff” to push the market lower in the fourth quarter, and they recommend investors sell the stocks that have lagged so far this year.

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Fiscal Cliff Rescue

Goldman chief U.S. equity strategist David Kostin writes that the S&P 500 should fall sharply after the election when investors finally realize that there is a possibility that the so-called “fiscal cliff” will not be resolved smoothly. He says the majority of investors expect to see the fiscal cliff avoided in the lame duck session of Congress, but Goldman sees a one-in-three chance that Congress will fail to address the issue. (Read More: What Stock Market Is Saying About November Elections)

The so-called “cliff” is the slam the economy would take from the expiration of Bush-era tax cutsand the automatic spending cuts that will hit the budget Jan. 1 if Congress does not act. The $100 billion spending cuts were agreed to as part of the debt ceiling compromise and are onerous, with a disproportionate hit going to the defense budget. (Read More: Leaders Remain Far Apart on ‘Fiscal Cliff’ Fix)

Kostin expects the S&P 500 , starting this week at 1,460, to fall to 1,250 by year end and then rise back to be at 1,350 in 12 months. Meanwhile, many big investors lag the S&P’s 18 percent advance year-to-date, with the typical levered investor seeing a return of just about 6.7 percent. Only 8 percent of hedge funds are outperforming the S&P, he notes. (Read More: Stocks Could Tumble 20% if Lawmakers Flub 'Fiscal Cliff')

Reasons to Go Over the Fiscal Cliff?

CNBC's Eamon Javers reports why both political parties may be willing to let the nation fall off the fiscal cliff.

Goldman says a catch-up strategy could be to sell stocks that have had the worst performance year-to-date, counter intuitive to the theory by many managers that they should buy the losers and sell winners. Kostin notes the strategy of selling losers has outperformed about 56 percent of the time since 1980, and it was particularly successful in years where the S&P was positive during the first nine months.

In the 23 years that the S&P was positive in the first nine months, a sector-neutral basket of underperforming stocks continued underperforming by an average 291 basis points during the fourth quarter, giving the strategy a 65 percent outperformance rate.

In most years, the S&P 500 rose in the fourth quarter, and the strategy returned 177 basis points versus the market. But in the six years that were negative in the fourth quarter, as Goldman suggests this year will be, the strategy worked four of six times, delivering an average of 270 basis points.